Beneficiary Designations

When you think of estate planning, you probably think about passing your assets to your loved ones using a Will or Trust. While Wills and Trusts are the primary estate planning vehicles, some assets don’t pass via a Will or Trust. In fact, even if you don’t have a Will or Trust, you’ve probably already started estate planning – and you may not even be aware of it.

Some assets do not pass via a Will or Trust because they are governed by another agreement. Life insurance and retirement accounts are examples of assets that are not typically governed by your estate plan. Both life insurance and retirement accounts are contractual relationships between the policy or account owner, the named beneficiaries, and the insurance company or account custodian. These types of assets will pass according to the beneficiary designation on the policy or account.

Do you remember filling out some forms when you purchased your life insurance or set up your retirement account? If you do, you may recall being asked to name a beneficiary who would receive the funds left in the account or due under the policy upon your death. Since life insurance and retirement accounts are contractual relationships, when the owner of a life insurance policy or retirement account dies, the funds must be paid according to the contract, regardless of what the owner’s Will or Trust says.

Since life insurance policies and retirement accounts are often some of the largest assets people own, extra care must be taken to ensure that the right people are named, and named properly.

How Should I Name My Beneficiary?

Properly naming your beneficiary or beneficiaries is an important part of ensuring your assets are transferred to the right people. If your life insurance company or custodian of your retirement account cannot identify the beneficiary named, it will almost certainly delay the transfer of the assets to the intended beneficiary. In addition, your beneficiary could end up having to pay legal fees if a court has to decide who the beneficiary is. These types of issues can be easily avoided by properly naming your beneficiary. Identifying your beneficiary by name and relationship typically won’t cause any problems for your beneficiary. So, you beneficiary designation might say “John Smith, my son” or “Wendy Smith, my wife” or even “John Smith, my son and Jane Smith, my daughter.”

While identifying your beneficiaries by name and relationship is the best course of action to avoid confusion, it may not be possible for everyone. For example, maybe you don’t want to name each child individually, especially if you are considering having more children. In that case, stating “all my surviving children” will effectively designate all of your children as beneficiaries – regardless of whether they are born before or after you completed your beneficiary designations. Treasury regulations do not require that a beneficiary be specified by name as long as the beneficiary is identifiable. However, there are potential problems that can arise when you name your beneficiaries so generally. If you just named “all my children,” while it may effectively designate your children as your beneficiaries, what would happen if one of your children predeceases you? Should that child’s share go to his or her heirs, the other beneficiaries, or someone else entirely? Whatever your wishes, you must make your intent clear when you name your beneficiary.

When naming your beneficiaries, you need to be sure to designate alternative beneficiaries in addition to your primary beneficiaries. If your primary beneficiary predeceases you, your asset will end up in your estate and may then subjected to the probate process and creditor claims.

Who Should I Name As My Beneficiary?

While properly naming your beneficiary is important, naming the right beneficiary is even more critical. Issues can arise if you designate a minor child as the beneficiary of a life insurance policy or retirement account. As a minor, the retirement account funds or life insurance proceeds cannot be paid directly to the child. Instead, a conservator will have to be appointed by the court to manage the child’s money. Getting the conservator appointed can cost between $3,000 – $5,000 or more and take months to accomplish. Later, when the child reaches the age of majority when he or she turns 18, the conservatorship will end and the remaining funds will be distributed to the child outright. The child can then immediately spend the funds on whatever foolish purchases an 18 year old may desire, or worse, lose all the money to a creditor. A better option is to name your trust and then to provide for your child in your trust. In a trust, the funds will be protected from creditors and you can control how and when your child gets the funds and even specify how the funds are to be used.

Regularly updating your beneficiary designations will also help ensure that you name the proper beneficiaries. Failure to do so can result in significant negative consequences for your family. Many people designate their spouse as the beneficiary. While for many people this isn’t a problem, it can be a very big problem if you get a divorce and forget to update your beneficiary designation. If you fail to update your beneficiary designation after a divorce, it could be that your ex-spouse ends up with your life savings, instead of your children. The best practice is to regularly review your beneficiary designations to ensure they are correct and to update your beneficiary designations any time you have a major life event (get married, divorce, have children, etc.).

Make Your Intent Clear

It is important that your intent is clear when you designate your beneficiaries. First you want to be sure that your intended beneficiaries are clearly identified. Second, if you want the assets to be specifically divided between beneficiaries (instead of being divided equally), you need to be clear on who gets what. For example, someone might say that $50,000 should to go to Sarah with the rest going to Vince. At the time account owner named the beneficiaries, there may have been substantial funds in the account. However, when the account owner dies, the account contains less than $50,000. Does Sarah get all of the money left in the account and Vince gets nothing? How is the money supposed to be divided in that situation? If you want to specifically divide your assets between beneficiaries, consider assigning a percentage to each beneficiary instead of a dollar figure. That way there will be no question about how the assets should be distributed, regardless of the account balance.

Consider Tax Consequences

Anytime one inherits assets, tax consequences need to be considered. If you designate someone other than your spouse as the beneficiary of your retirement plan, that person may have to take mandatory distributions and pay the resulting taxes on the money. If you name your spouse as the beneficiary, your spouse can roll your retirement assets in with his or her own retirement assets. In that case, your spouse won’t have to pay taxes on those funds until he or she begins taking distributions. If you want to leave retirement assets to someone other than your spouse, consider creating an IRA Inheritance Trust to be the beneficiary of funds held in an IRA. This option can have major tax benefits for retirement accounts with $150,000 or more. An IRA Inheritance Trust allows the beneficiaries to “stretch-out” payments from the IRA so that the funds can grow inside the IRA account without being taxed. For more information, read Richard Keyt’s article How Your Family Can Become IRA Millionaires Using an IRA Inheritance Trust that Protects the Funds from Ex-Spouses, Creditors and Bankruptcy Court.

Estate taxes can also be an issue. If you name someone other than your spouse as your beneficiary, the amount will be included in the value of your estate which could then trigger or increase estate tax liability. Often life insurance is one of the largest assets a family owns. When a person dies, the proceeds of a life insurance policy the person owned is included that person’s estate for estate tax purposes. However, this can be avoided if the person creates an Irrevocable Life Insurance Trust (or “ILIT”) to own the life insurance policy and be the beneficiary of the life insurance policy. Thus, designating an ILIT as the beneficiary of a life insurance policy can result in substantial estate tax savings.

Choosing and designating the beneficiaries of your life insurance policy or retirement account is an important step in the estate planning process. Proper beneficiary designations ensure that your life insurance policy proceeds or assets in your retirement fund will go to the people that you choose. However, although naming beneficiaries of life insurance proceeds or retirement funds is considered estate planning, you cannot rely on beneficiary designations alone for your estate planning needs. Other issues relating to health care, money management and who will care for your minor children cannot be addressed with beneficiary designations. With a good estate plan and well thought out beneficiary designations, you can protect your family and your assets and have peace of mind knowing your loved ones will be well taken care of when you can no longer do so yourself.